Britain’s three best Reits – Investors’ Chronicle

There are two main ways to unearth the UK’s best real estate investment trusts (Reits). The first is to focus solely on the market cycle. By any assessment, it’s clear that things have been a struggle since the era of ultra-low interest rates ended. As rates have risen, property valuations have slumped and transactions have dried up. The FTSE 350 Real Estate index fell 45 per cent between its peak at the end of 2021 and its trough at the end of October this year. That marked the index’s worst performance since the end of 2006 to March 2009 when it lost 79.6 per cent of its value.

Over the past two months, the index has started to mount a recovery, as confidence grows that the Bank of England has finished hiking rates and will turn its attention to rate cuts next year.

For those who back this narrative, conventional wisdom might say there has never been a better time to invest in Reits. Purchasing trusts currently trading at a discount to net asset value (NAV) means capturing their recovery at a bargain valuation, or so the thinking goes.

The problem with depending solely on the market cycle relates to the old warning about catching falling knives. The recent Reit rally could be a false dawn in a much longer and darker night for the asset class. And, on a case-by-case basis, there is no guarantee a given portfolio will recover from this downturn. Some might never recapture their former valuation highs, and for others the future could be worse still.

There is another way. Rather than focusing entirely on valuation and price, we have chosen three names in the sector that we think represent the best long-term investments. Discounts to NAV, dividend yields, or ‘buying the dip’ do not form the principal basis for these picks. Those considerations are often relevant – and these Reits are well-priced under some of those metrics – but that is not why we have chosen them. Instead, we have selected these Reits because we rate them as great companies.

To identify them, we looked at the attributes that underpin the commercial real estate business – rent, tenants, portfolio, development pipeline, market share, market size – to answer the central question: are these Reits good commercial landlords? Ultimately, this is the key to investing for the next five, 10, or 20 years. Share prices move by the minute, but quality is a stickier characteristic and a more difficult thing to find.

Segro: the ‘shed’ giant

The largest Reit by market cap, Segro (SGRO) has been trading for over a century. In that time, it has amassed an enormous portfolio of warehouses – known in the industry as ‘sheds’ – and has seen them go through several valuation cycles. Segro, more so than the other two Reits we discuss below, has cratered in value due to the recent property downturn. However, it has the advantage of having seen this all before, given that it listed in 1988.

After a decade or more of riding the logistics boom, last year saw tough times return. The reason for Segro’s poor performance in 2022 was not just the rise in market interest rates. Investor excitement over the role played by warehouses in the rise of online shopping, a phenomenon turbo-charged by the pandemic, was deflated last year by Amazon’s (US:AMZN) warning that it had overexpanded its property footprint. As the asset class that gained the most value in 2021, warehouses lost the most value last year. 

Sheds were also the asset class most exposed to the rise in gilt yields, which shot up after the October 2022 ‘mini’ Budget and even briefly overtook the average investment yield for UK warehouses, a figure expressing annual rent as a percentage of a building’s value.

But if you filter out the valuation noise, the past few years for Segro have been solid. Net rental income – rental revenue less the costs of running the business but before valuation changes – has tripled since 2015. While valuations for warehouses have risen and fallen during that period, the underlying tenant demand for sheds has been consistent.

According to Savills’ (SVS) data, eager tenants leased 48mn square feet of warehouse space in 2022, the third-best year for ‘take-up’ on record – behind only 2021 and 2020. For the first half of this year, take-up returned to the pre-Covid average. This is likely to have made some investors bearish on the sector, but the macro trend is still positive.

Nationally, the amount of vacant warehouse space sits at 6.25 per cent, below the pre-pandemic average. And the drop in speculative development caused by the rise in interest rates paves the way for the vacancy rate to fall next year. This gives Segro plenty of scope to increase rents, just as it has been doing for over a decade.

Of course, these market fundamentals also benefit Segro’s rivals. And there are many of them. Tritax Big Box (BBOX), Tritax Eurobox (EBOX), Abrdn European Logistics Income (ASLI), Warehouse Reit (WHR), Urban Logistics (SHED), LondonMetric (LMP) and UK Commercial Property Reit (UKCM) are all warehouse-focused Reits, and some have also posted impressive increases in net rental income this year despite drops in their values. 

However, while many of its rivals are good companies, none has a portfolio quite like Segro’s: Tritax Big Box specialises in large warehouses; Tritax Eurobox and ASLI in those on the European continent; Warehouse Reit concentrates on mid-sized spaces; Urban Logistics in warehouses near urban centres; and LondonMetric and UKCM focus on a mix of assets. Segro also owns all of those kinds of assets. And its portfolio is easily worth more than those seven portfolios combined.

According to real estate agency Colliers, sheds are “cementing [their] position as the investor favourite” globally because of their “perceived greater stability and growth potential”. In Europe, it notes that “light industrial, manufacturing, open storage/truck terminals and cold/dark storage logistics facilities are all rising in popularity, backed by occupier demand”. This is good news for Segro, which now has a third of its assets on the continent as a complement to its UK holdings.

Investors often overlook this sheer scale. The sector has boomed and billions of private equity money has poured into UK logistics over the past decade, but Segro remains the UK’s largest warehouse landlord by far. It is the only Reit that can legitimately claim to have an ‘economic moat’ in this sense. Rather than being a constraint, its focus on warehouses, when combined with its size, gives it a portfolio that is more diverse than its peers. That makes it best placed to continue to tap into a trend that has far from run its course.

Unite: top of the class

Come next September, an all too familiar scene will play out in towns and cities across the country. Scores of students will scramble for university-approved accommodation, of which there will not be enough. Some may then choose to rent on the private market, some may stay at home, and others may rent a hotel room. What many students want – particularly those in their first year of university – is to stay in halls of residence close to the university with other students. Many will not be able to achieve that.

The figures explain why. According to the Higher Education Statistics Agency (HESA), the number of students in higher education hit an all-time high of 2.53mn for the 2019-20 academic year. That record has since been beaten twice over, with the total number for the 2021-22 year (the latest for which HESA has figures) standing at 2.86mn.

There are several reasons for this. A ‘bulge’ in UK demographics means the number of 18-year-olds will continue to rise for a few years. At the same time, international students, particularly those from China, India and Nigeria, are swelling in number.

This rise in overseas students from outside the EU has more than compensated for a drop-off in EU students since Brexit. They are attracted by the UK’s world-class universities, with Oxford and Cambridge ranking first and third globally according to the Times Higher Education rankings. Of the six best universities in Europe, five are British. Compared with the US, which boasts many of the world’s best higher education institutions, UK tuition fees are cheaper and the immigration system less arduous. Compared with Europe, UK universities are better and deliver teaching in a language that many students see as an additional path to future success.

Meanwhile, the amount of buy-to-let student housing available in the UK is falling. “Since 2017 there have been over 300,000 buy-to-let mortgage redemptions across the UK, as regulation and tax changes have made investment less attractive for private landlords,” said Savills in a student housing report this May. “As a result, there are currently 31 per cent fewer five or more bed properties listed for rent in Q1 2023 compared with the pre-pandemic average.”

With buy-to-let student digs dwindling, private equity and institutional investors are spending big to build brand-new purpose-built student accommodation (PBSA) to replace it. In 2022, while total commercial property investment sank 14.2 per cent, investment in student housing surged 89 per cent to £7.9bn.

Despite this, PBSA stock is still not emerging from the ground fast enough. According to student accommodation website StuRents, there is currently a shortage of 283,000 student beds in the UK. Based on population trends and the number of PBSA buildings at the planning stage, it forecasts that the growing popularity of British universities will far outpace the development of new PBSA for years to come, leading to a 621,000 student bed shortage by 2026.

In short, despite the billions that PBSA developers have poured into the gap in the student housing market, there remains a massive gulf between demand and supply. And, as the UK’s self-proclaimed “largest owner, manager, and developer of PBSA”, it is hard to imagine another company that has benefited more from this imbalance than Unite (UTG).

Like Segro, scale is a bull point for Unite. One reason why rivals have failed to outgow it is Unite’s network of relationships with universities. Where other PBSA developers, such as Unite’s largest Reit rival Empiric Student Property (ESG), develop speculatively according to market demand, Unite builds half of its accommodation according to pre-existing contracts with universities which pay it to house their students. Unite has secured those agreements by being one of the earliest movers. Latecomers to the sector, no matter how well-funded, may struggle to compete.

That is not to say the company is invincible. Its stellar growth was interrupted in 2020 and 2021 when Covid-19 drove many students back to their home towns. Overnight, Unite’s buildings emptied, and convincing students to come back was no easy feat at first. The whole episode raises questions about Unite’s covenant strength. Because its leases essentially run one academic year at a time, there is no guarantee in any given year that it won’t suffer a significant drop-off in income. It has its university contracts, but these only cover half its revenue.

A black swan event such as the pandemic need not be the only cause of a demand slump, either. If rents become too expensive, students may choose to work from home or forego university altogether. The domestic demographic shift that is likely to lead to a student boom until 2030 is forecast to recede after that. And the Chinese students flocking to UK universities in their thousands may increasingly opt for universities in and around their home country instead, with China home to two of the world’s top 20 and nearby Singapore home to another.

There is also a downside for Unite if things go the other way. If demand increases even more than is anticipated, Unite will not be able to increase its rent as much as its competitors. Those university contracts that keep it relatively safe if the market goes south inhibit its ability to be competitive on rents when the market is flying.

Still, while would-be shareholders should educate themselves on Unite’s bad marks, they should not overstate them. What the company’s contracts sacrifice in upside, they should make up for in stability for years to come. Unite is likely to be top of the class in the long term.

Shaftesbury Capital: West End giant

When valuing Shaftesbury Capital (SHC), investors could try to make sense of what the combination of its former selves – Shaftesbury and Capital & Counties – means for its future by diving deep into the numbers. Or they could ask themselves the more nebulous question of what the West End as a cultural institution is worth. Specifically, how much are Covent Garden, Chinatown and large chunks of Soho, Carnaby Street and Fitzrovia worth?

Arriving at that figure would be difficult. Shaftesbury Capital’s entire value comprises what we have previously dubbed ‘intangible tangible assets’ – tangible assets with additional cultural value attached. This kind of valuation can be taken too far, as when Japan’s Imperial Palace was considered more valuable than the state of California during the 1980s. The idea is absurd, but it shows how challenging it is to value buildings and spaces whose worth has more to do with history and communities than bricks and mortar.

As for hard numbers, Shaftesbury Capital’s share price performance and earnings have been pretty dismal over the past decade. The rise of online shopping combined with Covid-19 has given its portfolio a hard knock. But the pandemic is now over, and its assets are arguably more valuable than ever. A trading update last month showed that its tenants’ sales figures are 12 per cent above 2022 levels and 16 per cent above 2019 levels. What’s more, as the performance of the warehouse market shows, the peak of online shopping’s popularity may have passed.

In any case, it is difficult to imagine Covent Garden, Soho and the rest of the West End struggling due to further growth in internet shopping. The West End is not a high street in a typical sense, but a destination for tourists and many Londoners alike. That should insulate it even if 2023’s sales ultimately turn out to have been partly driven by post-pandemic ‘revenge’ spending.

The real question is whether or not Shaftesbury Capital can turn this cultural capital into shareholder value over the next decade. Take the community of Chinese businesses renting space in the Reit’s Chinatown district as an example. A surge in vacancy in that portfolio seems unlikely due to the popularity of the area. Even so, the very fact that tourists, locals and the Chinese diaspora expect Chinatown to remain Chinatown limits Shaftesbury’s options if one or two of the tenants decide to exit their leases. 

Replacing an independent Sichuan restaurant with a pizza chain is an unwise move in the long term, even if the latter is willing to pay significantly more rent. The next incoming business has to align with the area. Otherwise, the additional cultural capital Shaftesbury Capital’s portfolio has is diminished.

Shaftesbury Capital is also limited in growth by acquisition. That may seem counter-intuitive, given the company has just swelled significantly via a merger and has since said it wants to ‘recycle’ 5 per cent of its portfolio into better opportunities. Indeed, from the start of July to the middle of November, it sold £82mn of assets at 12 per cent ahead of their June 2023 valuation.

However, while further deals are available, such as buying one of its joint ventures or acquiring more property in and around the West End, the fact remains that Shaftesbury does not have as many options as other Reits. Shareholders do not expect, and would not want, to see it acquiring a material number of assets in far-flung districts of London or beyond the capital.

Growth, therefore, will need to come from rental increases. The company has a rather ambitious 5 to 7 per cent annual rental growth target for the medium term, which should allow it to grow and pay dividends quite handily. Potential barriers in the short term are inflation, high interest rates and the looming threat of a recession.

The company looks ready for the challenge. Earlier this month, it shook up its leadership team, reducing the overall size of the board and increasing the influence of former CapCo directors. After Brian Bickell’s 12 years at the helm of the former Shaftesbury and nearly four decades at the company, the recent turnover signals a new direction and some necessary ambition.

Meanwhile, resurgent West End sales figures show people want to come and spend in the area. Its rock-bottom vacancy rate of 2.2 per cent also shows tenants are keen to rent in the area, and this is before the wider economic recovery that must, eventually, emerge in the UK. When it happens, tenants will be tripping over themselves to rent space from Shaftesbury Capital even more than they are already.

After all, countless developers eager to create destinations through ‘placemaking’ are basing their offering on what the West End already has in spades.

Land Securities (LAND), British Land (BLND) and Hammerson (HMSO) are just some of the big hitters claiming to be the owners and developers of ‘mixed-use’ spaces. The thinking goes that office tenants do not just want to rent space in a lifeless office block, retailers do not want to rent space in a lifeless shopping centre, and people do not want to rent a flat in a lifeless neighbourhood. The three need to weave together seamlessly. But what mixed-use developers are trying to create is nothing more than what places such as Soho, Fitzrovia and Covent Garden already have.

And just as Reits are trying to create what Shaftesbury Capital already has in the West End, so too are they and others trying to create what Segro and Unite already have in the world of warehouses and student accommodation, respectively. This is what makes all three companies such great investments. Investors may covet short-term successes. But, over the long term, it is hard to bet against quality commercial landlords who can make their rivals jealous, and have the ability to withstand the competitive threat from them.